Water Supply: Forests act as a regulator of water during both dry and wet seasons, leading to an increase in minimum flows during the dry seasons.

Aquatic Productivity: The quality of fisheries is closely linked to the conditions of adjacent upstream watersheds.

By keeping water clean at its source, investing in watersheds' services may be far more cost-effective than traditional pollution control strategies. Incentive mechanisms may also be tailored to support livelihoods of rural or poor natural resource managers. A range of models exist based on this concept, which have been variously called, "investments in watershed services," “payments for watershed services,” “reciprocal agreements for water,” “water funds,” “eco-compensation,” and “benefit-sharing arrangements.”

This primer offers an introduction to watershed investments, including the underlying concepts, some general types of projects, and leading examples from around the world. The concept of watershed investments is a flexible one, and in practice, projects are as varied as the communities and countries in which they take place.

The Basics

Healthy watersheds do much the same work as a water treatment plant and other ‘grey' technologies, but without the expensive equipment and with added benefits like protection of wildlife habitats and carbon sequestration. Natural ecosystems can filter out water pollution, regulate stream flows, recharge aquifers, and absorb flooding. These benefits are collectively known as “watershed services,” and society can't do without them. (See Box 1 for an example of all the watershed services that forests may provide.)

We tend to take these benefits for granted. Water utilities don't list watersheds as assets anywhere on their books, and landowners aren't rewarded for good management practices that result in downstream users receiving clean, ample water.

That's beginning to change. Leaders and communities around the world are moving to recognize the ways in which we depend on natural systems and incorporate those values into our economic decisions. Watershed investments put this concept into action. A watershed payment mechanism invests in our natural infrastructure and compensates those who protect it, in recognition of the benefits provided. It's a powerful tool for funding conservation, is often more cost-effective than traditional large engineering solutions to water problems, and can provide new revenue streams to rural and often poor communities in resource-rich areas around the world.

Box 2. Market Snapshot

Active programs: 205 Total programs: 282

Total dollars transactedin 2011: $8.17 billion

Total transactions from 1973-2011: 66 billion

Total area protected: 117 million hectares

Total area protected 1973-2011: 195 million hectares

Total nutrient reduction: 439,864 million Lbs

Total water restored: 138,000 Megaliters

Share of projects for which some transaction data is available: 43%

*Excluding agri-environmental programs.

The watershed payment principle in action

In practice, project design varies according to goals and the larger context. Regulatory and institutional frameworks, local politics, the nature of environmental problems, and the suite of potential management interventions are all factors to consider in designing an incentive mechanism. Our Project Development Cycle tool guides users through the process of project design, from scoping the issues to feasibility assessment, implementation, and monitoring.

Within that framework, there are a few general categories. These include:

Investments in Watershed Services (IWS) Model

In Ecuador, the Pimampiro municipality pays upstream landholders to protect forests and high altitude grass- lands, in order to regulate flows and improve water quality downstream. Funding comes from mandatory municipal water user fees. Learn more about this project.

The city of Munich, Germany pays agricultural producers to switch to organic methods to reduce agricultural pollution of city water supplies. Farmers participate voluntarily and receive direct payments and technical support. Learn more about this project.

In the Philippines, hydroelectric companies in the Bakun watershed voluntarily channel payments through local government to communities in the upper watershed, who implement agricultural management practices to limit sedimentation in reservoirs, which lowers hydroelectric plant operating costs. Learn more about this project.

In the Min River Watershed in China, Fuzhou, a downstream city, will pay upstream cities, Sanming and Nanping, for pollution control, source water protection and waste disposal in the basin. Learn more about China's growth in the IWS sector in the State of Watershed Payments 2012 Report.

Core Program Types

Bilateral Agreements

Based on the most up to date data, bilateral agreements are the largest group tracked. In such agreements, downstream water users pay upstream land users for better management practices. And while multiple payers and providers may be involved, the contracts between these two groups are always made bilaterally. Government agri-environmental payments often fall into this category.

Beneficiary-Pays Fund

Here, individuals or organizations who benefit from watershed restoration or preservation contribute to a centralized fund, often matched by public co-investment. Generally, a council, trustee or committee will then decide how to use the money to invest in the watershed. The payers or, beneficiaries, participate voluntarily or may be required to through mandatory fees. These are usually on a local level and are most often seen in Latin America. Learn more here.

Trading & Offsets

The “polluter pays” principle is often an underlying force of this type of IWS. There is usually a linked regulatory driver for participation, particularly on the side of the buyer. In these cases, there is often a high amount of commoditization of watershed services, often paired with some kind of marketplace exchange arrangement. Learn more here.

Instream Buybacks

Instream buybacks are the purchase of water rights for the purpose of leaving that water instream (rather than diverting it for irrigation, drinking, or some other consumptive use) to restore natural flow regimes. These transactions usually have a strong biodiversity co-benefit component and can only be done in places with defined property rights for water extraction. Usually the buyer is a government or non-profit organization. Instream buybacks have only taken place in Australia and the US. Learn more about the water buybacks of the Murray-Darling river system in Australia here.

Box 3. Key Elements of Project Design

Design Element

For example…

Hydrological Service Goals: What problem is this mechanism trying to solve?

Groundwater infiltration, filtering of pollutants, or trapping of sediments

Scale: At what geographic level do investments occur?

-Local or watershed-scale -Regional, spanning multiple watersheds or jurisdictions, or encompassing a major basin -National, active in multiple areas or across an entire country

*Beneficiary - The individual/organization that enjoys the benefits of watershed services Provider - The individual/organization whose land management actions can be linked to delivery of watershed services to beneficiaries. Management action - Interventions that harm or enhance watershed services. This can include soil and water conservation measures in agricultural production, restoring river banks, or reducing pollution loading into waterbodies.

Payment mechanism - The means by which payment is transferred between beneficiaries and providers of watershed services. This might be through a water fund, intermediary organization, bilaterial contract, or auction, to name just a few. The three general categories are payments for watershed services, and water quality trading, but within these categories mechanisms can vary by the actors involved, basis and terms of payment, and type (cash or in-kind, such as technical support, management inputs, or tenure recognition).